Africa: Profiling Cash Drains

Editor's Note

"Estimates [for the period 1970-2008] show that over the 39-year
period Africa lost an astonishing US$854 billion in cumulative
capital flight--enough to not only wipe out the region's total
external debt outstanding of around US$250 billion (at
end-December, 2008) but potentially leave US$600 billion for
poverty alleviation and economic growth. Instead, cumulative
illicit flows from the continent increased from about US$57
billion in the decade of the 1970s to US$437 billion over the
nine years 2000-2008." - report by Global Financial Integrity

These estimates based on available data, the report authors also
note, are without doubt conservative underestimates. Adjusting for
some of the known data flaws, they suggest the figure might be more
than double, at $1.8 trillion. And even this larger figure, they
note, does not include proceeds that are never recorded, such as
from drug trafficking and smuggling.

Strikingly, the report argues that explicit corruption, such as
bribes, account for only a small portion of capital flight. By far
the largest component is, instead, generated by commercial tax
evasion through trade misinvoicing.

This AfricaFocus Bulletin contains excerpts from the study "Illicit
Financial Flows from Africa: Hidden Resource for Development."
released by Global Financial Integrity on March 26. Also included
is a short article by L‚once Ndikumana and James K. Boyce, authors
of a 2008 report on the same subject. Ndikumana and Boyce argue
that those who owe Africa's debt are actually those who have
illegally transferred wealth overseas, and that African countries
should identify debts as "odious" and refuse payment unless the
creditors are able to prove that the loans were actually spent for
the intended purpose instead of siphoned overseas.,

Illicit Financial Flows from Africa:
Hidden Resource for Development

Prepared by Dev Kar and Devon Cartwright-Smith

Dev Kar, formerly a Senior Economist at the International Monetary
Fund (IMF), is Lead Economist at Global Financial Integrity (GFI)
at the Center for International Policy, Washington DC, and Devon
Cartwright-Smith is an Economist at GFI.

In December 2008 Global Financial Integrity released its
groundbreaking analysis of Illicit Financial Flows from Developing
Countries: 2002 - 2006. We estimated such flows at $859 billion to
$1.06 trillion a year.

We are pleased now to release our analysis of Illicit Financial
Flows from Africa: Hidden Resource for Development. This study
examines the 39-year period from 1970 through 2008. ...we estimate
that such flows have totaled $854 billion across the period
examined. This estimate is regarded as conservative, since it
addresses only one form of trade mispricing, does not include the
mispricing of services, and does not encompass the proceeds of
smuggling. Adjusting the $854 billion estimate to take into
account some of the components of illicit flows not covered, it is
not unreasonable to estimate total illicit outflows from the
continent across the 39 years at some $1.8 trillion.

Much attention has been focused on corruption in recent years, that
is, the proceeds of bribery and theft by government officials. In
the cross-border flow of illicit money, we find that funds
generated by this means are about 3 percent of the global total.
Criminal proceeds generated through drug trafficking, racketeering,
counterfeiting and more are about 30 to 35 percent of the total.
The proceeds of commercial tax evasion, mainly through trade
mispricing, are by far the largest component, at some 60 to 65
percent of the global total. While we have not attempted in this
study to verify these approximate percentages for Africa, we
believe that they are likely to be of roughly the same order of
magnitude.

This massive flow of illicit money out of Africa is facilitated by
a global shadow financial system comprising tax havens, secrecy
jurisdictions, disguised corporations, anonymous trust accounts,
fake foundations, trade mispricing, and money laundering
techniques. The impact of this structure and the funds it shifts
out of Africa is staggering. It drains hard currency reserves,
heightens inflation, reduces tax collection, cancels investment,
and undermines free trade. It has its greatest impact on those at
the bottom of income scales in their countries, removing resources
that could otherwise be used for poverty alleviation and economic
growth.

Addressing this problem requires concerted effort by both African
nations and by western countries. The outflow from Africa and the
absorption into western economies deserve equal attention. Through
greater transparency in the global financial system illicit
outflows can be substantially curtailed, thereby enhancing growth
in developing countries and at the same time stabilizing the
economies of richer countries. ...

Raymond W. Baker Director, Global Financial Integrity

...

I. Introduction

...

The purpose of this paper is not to explain the factors that drive
illicit financial flows or to carry out a series of econometric
tests seeking to determine their significance. There is a wealth of
existing research on these subjects. Rather, we analyze the
long-term evolution of illicit flows from the continent and its
various regional and economic groupings. ... we also point out
certain common pitfalls in data interpretation.

...

II. Models of Illicit Financial Flows

Illicit money is money that is illegally earned, transferred, or
utilized. If it breaks laws in its origin, movement, or use it
merits the label.

Flight capital takes two forms. The legal component stays on the
books of the entity or individual making the outward transfer. The
illegal component is intended to disappear from records in the
country from which it comes. By far the greatest part of
unrecorded flows are indeed illicit, violating the national
criminal and civil codes, tax laws, customs regulations, VAT
assessments, exchange control requirements, or banking regulations
of the countries out of which the unrecorded/illicit flows occur.

There are two main channels through which illicit capital,
unrecorded in official statistics, can leave a country. The World
Bank Residual model captures the first channel through which
illicit capital leaves a country through its external accounts.
The second type of illicit flows, generated through the mispricing
of trade transactions, is captured by the Trade Misinvoicing model
which uses IMF Direction of Trade Statistics.

Specifically, the World Bank Residual model compares a country's
source of funds with its recorded use of funds. Sources of
funds--the countries inflows of capital--include increases in net
external indebtedness of the public sector and the net inflow of
foreign direct investment. The net external indebtedness is derived
by calculating the change in the stock of external debt which was
obtained from the World Bank's Global Development Finance
database. Use of funds includes financing the current account
deficit and additions to central bank reserves. Both these data
series along with data on foreign direct investment were obtained
from the IMF Balance of Payments database. According to the model,
whenever a country's source of funds exceeds its recorded use of
funds, the residual comprises unaccounted-for, and hence illicit,
capital outflows.

Trade misinvoicing has long been recognized as a major conduit for
illicit financial flows. By overpricing imports and underpricing
exports on customs documents, residents can illegally transfer
money abroad. To estimate trade misinvoicing, a developing
country's exports to the world are compared to what the world
reports as having imported from that country, after adjusting for
insurance and freight. Additionally, a country's imports from the
world are compared to what the world reports as having exported to
that country. Discrepancies in partner-country trade data, after
adjusting for insurance and freight, indicate misinvoicing.
However, note that this method only captures illicit transfer of
fund abroad through customs re-invoicing; IMF Direction of Trade
Statistics cannot capture mispricing that is conducted on the same
customs invoice (for which we make an adjustment in Section IV).

...

One should bear in mind that there are a number of limitations
underlying the two models used to estimate illicit flows. First,
no economic model that relies on official data to estimate illicit
flows can capture the effects of smuggling which entirely bypasses
customs authorities and their recording systems. Smuggling tends to
be rampant when there are significant differences in cross-border
prices in certain goods between countries that share a long and
porous frontier. The profits from smuggling often end up as part of
outgoing illicit flows since smugglers seek to shield their
ill-gotten gains from the scrutiny of officials, even as smuggling
distorts the quality of bilateral trade. As a result, trade data
distortions due to smuggling may indicate that there are inward
illicit flows into a country when in fact the reverse is true.
Economic models that rely on official statistics also cannot
capture illicit flows generated through transactions in narcotics
and other contraband goods, human trafficking, violations of
intellectual and property rights, and the sex trade because
related financial flows are not recorded in any books. Hence,
economic models understate the actual volume of illicit flows to
the extent that these types of illegal transactions are significant
for both developing and developed countries.

..,.

III. The Pattern and Evolution of Illicit Flows from Africa

Existing research shows that African countries have experienced
massive outflows of illicit capital mainly to Western financial
institutions. In fact, Ndikumana and Boyce (2003, 2008) among
others find that the continent as a whole has turned into a net
creditor to the world. The irony is not lost on bilateral and
multilateral creditors who have together provided Africa with
substantial and growing amounts of external aid over several
decades. Other researchers such as Collier, Hoeffler and Pattilo
(2001) point out that many African investors seem to prefer
foreign over domestic assets to the extent that the continent now
has the highest share of private external assets among developing
regions with serious ramifications for self-sustaining economic
growth which allow countries to graduate from aid dependence.

Estimates presented in Table 1 show that over the 39-year period
Africa lost an astonishing US$854 billion in cumulative capital
flight--enough to not only wipe out the region's total external
debt outstanding of around US$250 billion (at end-December, 2008)
but potentially leave US$600 billion for poverty alleviation and
economic growth. Instead, cumulative illicit flows from the
continent increased from about US$57 billion in the decade of the
1970s to US$437 billion over the nine years 2000-2008.

...

While the overwhelming bulk of this loss in capital through
illicit channels over the period 1970-2008 was from Sub-Saharan
African countries, there are significant disparities in the
regional pattern of illicit flows (Chart 2). For example, capital
flight from West and Central Africa, by far the dominant driver of
illicit flows from the Sub- Saharan region, is mainly driven by
Nigeria which is also included in the economic group "fuel
exporters". In fact, the proportion of illicit flows from West and
Central African states may be somewhat overstated, given that other
regions of Africa include many countries that are poor reporters of
data and thereby understate their contributions to illicit flows.
For example, flows from the Horn of Africa (represented by the
narrow red sliver in Chart 2) are likely to be understated
particularly in the earlier decades due to incomplete balance of
payments and bilateral trade data from Eritrea, Somalia, and
Sudan, which have been historically unstable and prone to conflict.
By the same token, civil strife for some periods in the Democratic
Republic of the Congo, Rwanda, and Uganda are reflected in
incomplete and poor quality data which likely understate the
volume of illicit flows from the Great Lakes region. Hence, the
long-term evolution of illicit flows from the different regions of
Africa need to be interpreted with caution in light of such data
deficiencies.

... the estimates indicate that Africa lost around US$29 billion
per year over the period 1970-2008, of which the Sub-Saharan
region accounted for $22 billion. On average, fuel exporters
including Nigeria lost capital at the rate of nearly $10 billion
per year, far outstripping the $2.5 billion dollars lost by
non-fuel primary commodity exporters per year. ...

Table 1 also shows that real illicit flows from Africa grew at an
average rate of 12.1 percent per annum over the 39-year period.
Some of the acceleration in illicit outflows was undoubtedly driven
by oil price increases and increased opportunities to misprice
trade that typically accompany increasing trading volumes due to
globalization. The rates of outflow in illicit capital for West
and Central Africa (14.5 percent) as well as Fuel-exporters (21.8
percent) over the entire period 1970-2008 reflect substantial
outflows from Nigeria and Sudan. The acceleration of illicit
outflows in 2000-2008 from both these regions coincide with
unprecedented increases in oil prices. This seems to corroborate
Almounsor (2005), who found a significant link between oil price
increases and capital flight.

...

Per capita, the North Africa region (comprising of Algeria, Egypt,
Libya, Morocco, and Tunisia) lost $1,767 in investable capital
over the 39-year period with Southern Africa and West and Central
Africa following closely behind at approximately $1,334 and $1,313
per capita, respectively. Again, except for the dip in the 1990s,
the loss of illicit funds per capita has been steadily increasing
over the period across most regions of Africa in spite of the high
rates of population growth prevalent throughout the continent.

...

How do some of these estimates compare with past research? While a
number of past studies present evidence of substantial illicit
financial flows from Africa, the study by Ndikumana and Boyce
(2008; available at http://www.peri.umass.edu/236/hash/61e07e4377/publication/301/) is
the most recent and comprehensive one on the subject. They
estimate illicit flows (or illegal capital flight) for a sample of
40 Sub-Saharan African (SSA) countries over the period 1970-2004
and find evidence of a "revolving door" effect between the
contracting of external debt and illicit outflows. Over the 35-year
period, real capital flight (in 2004 dollars) from the SSA
countries amounted to $420 billion, which would jump to $607
billion if one were to include imputed interest earnings.

In contrast, we adopted a conservative approach to estimating
capital flight in that we omitted a country from the total if we
deemed that its data were unreliable or if some of the data were
incomplete. For the same sample size and time period as the
Ndikumana and Boyce study, we find that Sub-Saharan Africa as a
whole lost US$282 billion in real 2004 dollars over the period
1970-2004; extending the period to 2008 sharply increased the
cumulative total to US$533 billion.

...

On balance, our findings corroborate Ndikumana and Boyce in that
the stock of private assets held abroad by Sub-Saharan Africans
exceeds the combined stock of the region's external debt, thereby
making it a net creditor to the world. This finding is not
surprising given that, except for a small decline in the 1990s,
average illicit flows from the continent have been ratcheting
upwards every decade since the 1970s (Chart 4).

...

IV. Adjustment for the Underestimation of Illicit Flows

For reasons pointed out in Section II including limitations of
economic models, there is no question that illicit financial flows
are significantly understated. In this section, we attempt to
correct for some of the factors responsible for the
underestimation while clearly recognizing the limitations of such
methods. It should be noted that adjustments to include illicit
flows generated through illegal activities such as smuggling, trade
in narcotics and other contraband goods, human trafficking, the
sex trade, and other illegal activities, are outside the scope of
this paper. Nevertheless, the exercise provides some guide to the
margins of error associated with the estimation of illicit flows.
Table 3 (page 20) presents the adjusted estimates in the following
sequence of calculations.

...

As a result of these adjustments, total illicit flows from Africa
over the period 1970-2008 more than double from US$854 billion to
US$1.8 trillion. While this is a staggering volume of illicit
outflows, it is likely to be still higher if we were to include
flows due to other illegal activities.

...

V. The Development Impact of Illicit Flows

The enormity of such a huge outflow of illicit capital explains why
donor-driven efforts to spur economic development and reduce
poverty have been underachieving in Africa. Policy measures must be
taken to address the factors underlying illicit outflows and also
to impress upon the G-20 the need for better transparency and
tighter oversight of international banks and offshore financial
centers that absorb these flows.

Research at Global Financial Integrity shows that the massive
outflows of illicit capital are not just due to sub- optimal
policies in individual developing countries but rather that such
policies find synergy in deep flaws within the global financial
system. ...

So long as illicit capital continues to hemorrhage out of poor
African countries over the long term at a rapid pace, efforts to
reduce poverty and boost economic growth will be thwarted as income
distribution becomes ever more skewed leading to economic and
political instability.

The current global financial crisis, which has generated a
world-wide public backlash against the lack of transparency and
excesses of financial institutions, offers both African and rich
donor countries an historic opportunity to address the problem of
illicit flows and absorption of such flows in the world's shadow
financial system. The existing global financial system shaped by
liberalization and deregulation of financial markets have instead
ended up generating ever-rising illicit flows and loss in
government revenues. ...

The time is right for African countries to not only implement
strong economic and governance measures to curtail illicit flows
but to impress upon the G-20 the need to correct their failures in
oversight and regulation that have facilitated the absorption of
illicit flows and contributed to the current economic crisis.

Capital Flight from Sub-Saharan Africa

"The real counterpart of many assets on the balance sheets of
creditor banks is private deposits in many of the same banks by
individuals belonging to Africa's political and economic elites."

Capital flows between sub-Saharan Africa and the rest of the world
present a striking paradox. On the one hand, African governments
are heavily indebted and have been forced by external debt burdens
to undertake painful economic adjustments in recent decades,
curtailing the provision of vital social services to their
populations while devoting scarce foreign exchange to debt-service
payments. On the other hand, sub-Saharan African (SSA) countries
have experienced massive outflows of private capital to Western
financial centres. Indeed, these private assets surpass the
subcontinent's foreign debts.

In the 35-year period from 1970 to 2004, total capital flight from
40 SSA countries amounted to $420 billion (in 2004 dollars),
compared to a total external debt at the end of this period of
$227 billion. If we impute interest earnings on flight capital,
the accumulated stock of capital flight at the end of 2004 was
even greater at $607 billion.

Sub-Saharan Africa in this sense is a net creditor to the rest of
the world: the region's external assets exceed its external
liabilities. But there is a crucial difference between the two:
the subcontinent's external assets belong to private individuals,
whereas the external debts are borne by the governments, and
through them by the African people as a whole.

Adding to the irony of SSA's position as net creditor is the fact
that a substantial fraction of the money that flowed out of the
country as capital flight appears to have come to the
subcontinent via external borrowing. Part of the proceeds of loans
to African governments from official creditors and private banks
has been diverted into private pockets - and foreign bank
accounts - via bribes, kickbacks, contracts awarded to political
cronies at inflated prices, and outright theft. Some African
rulers, like Congo's Mobutu and Nigeria's Sani Abacha, became
famous for such abuses.

This phenomenon was not limited to a few rogue regimes.
Statistical analysis suggests that across the subcontinent the
sheer scale of debt-fueled capital flight has been staggering.
For every dollar in external loans to Africa in the 1970-2004
period, roughly 60 cents left as capital flight in the same year.
The close year-to-year correlation between flows of borrowing and
capital flight suggests that large sums of money entered and
exited the region through a financial "revolving door." This
implies that the real counterpart of many assets on the balance
sheets of creditor banks is private deposits in many of the same
banks by individuals belonging to Africa's political and economic
elites.

Our analysis of African capital flight in this period also reveals
a "debt overhang" effect, whereby increases in the accumulated
stock of external debt spurs further capital flight in subsequent
years. Rising debt may induce residents to shift liquid assets
abroad in anticipation of currency devaluation and other
macroeconomic problems. In the region as a whole, a one-dollar
increase in the debt stock on average triggered an additional 3
to 4 cents of capital flight per year. In other words, debt-driven
capital flight over the medium-to-long term exacerbated the
short-term hemorrhage caused by debtfueled capital flight.

Efforts to identify, recover and repatriate illicit private
fortunes held abroad are one way African people and their
governments can try to repair the damage. This is difficult,
however: it places the burden of proof on African governments to
locate and reclaim the money. The Stolen Asset Recovery (STAR)
initiative, launched last September by the World Bank and the
United Nations Office of Drugs and Crime, may help improve the
prospects. But forcible repatriation offers only limited
possibilities for easing SSA's debt burden.

A complementary strategy would be for African countries to
repudiate debts that financed the accumulation of private assets
on the grounds that these debts are odious. This is equivalent to
asset repatriation: it blocks the final spin of the "revolving
door." For Africa, the net capital loss from debt- fueled capital
flight comes not from the initial two-way flows but from the
resulting debtservice payments in subsequent years. African
countries cannot close the stable door after the horse has bolted,
but they can cut their losses because they haven't yet paid for
the horse. In addition, repudiating odious debt would help deter
future capital flight fueled by irresponsible lending.

In international law, a country's debts can be considered "odious"
if three conditions hold: (1) absence of consent: the debts were
incurred without the consent of the people, which is typically the
case when debts were borrowed by undemocratic regimes; (2)
absence of benefit: the borrowed funds were used not to benefit
the people, but instead benefited the rulers, possibly including
for repression against the people; and (3) creditor awareness:
creditors were aware or should have been aware of (1) and (2).

It is hard to distinguish, however, between legitimate debts and
odious debts. Putting the burden of proof on debtor countries to
establish the "odious" nature of debts could often impose
insuperable transaction costs. Another way would be to put the
burden of proof on the creditors to demonstrate the legitimacy of
the debts contracted by previous regimes. Sub-Saharan African
governments would tell their creditors that outstanding debts
will be treated as legitimate if, and only if, the real
counterparts of the debts can be identified and shown to have
benefited the people of the country. If the creditors can
document where the money went, and show when and how it benefited
citizens of the borrowing country via investment or consumption,
then the debt would be regarded as a bona fide external obligation
of the government (and hence an external asset of the creditor
bank or government). But if the fate of the borrowed money cannot
be traced, then the present African governments must infer that
it was diverted into private pockets associated with the former
regimes, and possibly into capital flight. In such cases, it can
be argued that the liability for the debt lies not with the
current government, but with the private individuals whose
personal fortunes are the real counterpart of the debt.

One possible objection is that lenders may retaliate and refuse to
lend to countries whose governments opt to repudiate odious
debts. But this concern may be exaggerated. Many African countries
currently receive little new net borrowing; indeed many today
experience negative net transfers, paying more in debt service
than they receive in new money. Such debtor countries can easily
endure the "punishment" of credit rationing. Moreover, invoking
the odious debt doctrine is not equivalent to across-the-board
debt repudiation. Legitimate creditors have no reason to fear,
given that legitimate loans will be duly repaid. Indeed the
prospects for their timely repayment will be enhanced if
countries now longer face the additional burden of servicing
illegitimate loans.

This strategy would also enforce and reward responsible lending
practices by western financial centres as well as transparent and
responsible debt management by African leaders. It could yield a
win-win outcome for lenders and borrowers. There is certainly a
risk that debtor countries would be overly expansive in defining
what constitutes "odious debt" if they could repudiate such debt
unilaterally, without recourse to legal proceedings to assess the
merits of the case. To address this concern, it would be useful
to establish an international institution to adjudicate questions
of debt legitimacy in developing countries, especially postwar
countries - a move that the Norwegian government proposed in
October 2005.

As Africa searches for ways to reach financial stability and to
increase resources for development financing, we believe that
addressing the problem of capital flight ought to feature
prominently in debates at the national level as well as in the
international development assistance community.

Total capital flight from selected African countries, 1970-2004
(million 2004 US $ and as % of external debt)

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